How the Postal Service began prefunding retiree health care and fell into a deep hole

The Government Accountability Office (GAO) has just issued a new report (GAO-13-112) on the Postal Service’s retiree heath care fund. It’s called “Status, Financial Outlook, and Alternative Approaches to Fund Retiree Health Benefits.”

As the title suggests, the report is about the current condition of the Retiree Health Benefits Fund (RHBF), projections about the Postal Service's health care liability in the future, and the potential impacts of the various changes in the law being proposed by the House, Senate, and Administration. What’s missing from the report is a little history.

Like most GAO reports on the Postal Service, this one is filled with dire predictions about the agency’s “ability to continue to fulfill its mission on a self-supporting basis.” (In other words, a government bailout may be on the horizon.) The GAO has issued a host of reports like this. They use a lot of charts and graphs to dramatize how bad the Postal Service’s financial condition is (always “high risk”), and they recommend radical solutions, like downsizing the workforce, cutting services, and closing facilities.

The GAO report projects massive health care costs for future retirees. It argues that any near-term reduction of payments into the RHBF will cause much larger payments in the long term. It says that if the Postal Service is unable to cover its liability, someone else will get stuck with the bill. Future postal customers (ratepayers) will face large rate increases, or the government (taxpayers) will have to step in with subsidies. It’s also possible, says the GAO, that postal workers may come out at the short end: “The level of employee pay and benefits may not be sustainable and could be reduced.”

“Therefore,” the GAO concludes, “we continue to believe it is important that USPS prefund its retiree health benefit liability to the maximum extent that its finances permit.”

The GAO report is addressed to Congressman Darrel Issa. That probably means Issa requested it, and from the look of things, the GAO has given Issa what he wanted — more ammunition with which to argue that the large retiree health care payments are necessary and inevitable. The fact that those payments are driving the Postal Service deeper and deeper into the red gives Issa and his friends more justification for the anti-union and anti-government cutbacks they’ve been advocating.

Fixing one mistake with another

In preparing the report, the GAO shared a draft with the Postal Service and the USPS Office of Inspector General. The comments of Inspector General David Williams are worth noting.

One of Williams' main points is that it’s important to understand the historical context of how the prefunding obligation came about in the first place. The Inspector General writes this in his letter to the GAO:

“The Postal Service started prefunding its retiree health benefits as a result of the discovery that, due to external fund management misjudgments, it was on track to seriously overfund its pension obligations by $78 billion. This discovery was one of several fund management issues identified about the same time. The decision to turn a mistake into a second prefunding obligation created its own problems. A 10-year schedule of prefunding payments was structured toward a 100-percent funding goal. The aggressive payment schedule appears to have been set based on byzantine ‘budget scoring’ considerations rather than actuarial assumptions or an evaluation of the Postal service’s ability to make the payments.”

In other words, the amount of the annual payments to the RHBF — around $5.5 billion — was not based on reasonable estimates of what needed to be put into the fund to cover the liability. The amount was determined by budget scoring.

According to the way scoring works, even though the Postal Service is an independent agency with its own budget, aspects of its operations are included in the unified federal budget, which consolidates all revenues and expenses of the government. Congress therefore estimates the effects of any legislation, proposed or enacted, on the federal budget. The goal is legislation that is budget neutral.

Those considerations, says Williams, determined the size of the annual payments to the RHBF, rather than an actuarial analysis of what they should have been. In response to Williams' comments, the GAO added a bit more background to its report, but not enough to fully understand how the excessive health care mandate came about.

Here’s the rest of the story. It's pretty complicated, so there may be a few errors in what follows, but it's based on several government reports and a few news articles, listed here.

From the “High Risk List” to “a much more positive picture”

In the late 1980s, Congress became concerned that the Postal Service would be unable to meet its pension liabilities, so it passed a series of laws to increase the agency’s payments. In 1989, for example, Congress required the Postal Service to pay for cost-of-living adjustments for its annuitants retroactive to 1986. The following year, Congress again increased the charges to the Postal Service for COLA payments by pushing back the applicable date to 1977. In 1993, Congress required the Postal Service to pay $693 million for past interest which had accrued as a result of the unfunded liability for COLAs and health benefits.

Despite these and other increases in the pension payments, the GAO was concerned about the “rapidly deteriorating financial situation” of the Postal Service and its ability to cover its liabilities. In April 2001, the GAO issued a report (GAO-01-598T) that focused on declining revenues, rising debt, management-labor relations problems, and increased competition (including electronic diversion to the Internet). As a result of these concerns, the GAO put the Postal Service on its “High Risk List.”

In May 2002, Comptroller General David Walker testified to the Senate (GAO-02-694T) that the Postal Service had major liabilities and obligations estimated at close to $100 billion, including liabilities for pensions ($32 billion), workers’ compensation benefits ($6 billion), debt to the Treasury ($11 billion), and post-retirement health benefits ($49 billion). That's the same David Walker who's CEO of the Peter G. Peterson Association and behind efforts to privatize the Postal Service.

At the request of Congress and the GAO, the Office of Personnel Management (OPM)
conducted a review of the Postal Service’s liability to the Civil Service Retirement System (CSRS). Such a study had never been done before, and almost everyone expected the OPM to discover that the liability would be even greater than current estimates were showing.

The actuaries went back into the books, and in November 2002, much to everyone’s surprise, the OPM discovered that “a review of USPS payments to the civil service retirement fund for pension obligations to employees on board before 1984 revealed a much more positive picture than previously believed.”

The OPM determined that rather than facing a huge pension liability, “contribution rates set in current law would ultimately result in an overfunding of the amount needed to cover CSRS benefit obligations attributable to USPS annuitants by $71.0 billion.”

The explanation for this surprising revelation was relatively simple: The pension fund was invested in Treasury bonds that were “earning interest at a higher rate than presumed in the statutory funding formula” (a static 5 percent).

The potential for overfunding was actually even more than $71 billion determined by the OPM. When a November 2003 GAO report (GAO-03-448R) looked at the OPM calculations, it put the potential overfunding at $103 billion.

The main difference between the OPM’s calculations and the GAO’s involved veterans working at the post office. Under then-current law, the Treasury was responsible for retirement benefits based on prior military service of postal employees. The OPM’s calculations had the obligation as belonging to the Postal Service. The GAO said that if the obligation — estimated at almost $27 billion — were considered the Treasury's responsibility and therefore added to the CSRS overfunding, the total overfunding would top $100 billion. (More on the military pension costs in a moment.)

In order to remedy the overfunding problem the OPM and GAO had uncovered, Congress needed to pass legislation that would change the way the Postal Service's CSRS retirement liability was calculated and funded.

In reviewing a draft of what would become the Postal Civil Service Retirement System Funding Reform Act of 2003 (Public Law 108-18), sponsored by Senator Susan Collins, the Congressional Budget Office (CBO) did some budget scoring and determined that the proposed bill would improve the financial position of the Postal Service but increase the federal deficit (or reduce a surplus) of the unified federal budget by as much as $41 billion over the 10-year period from FY2003 to FY2013.

In other words, if the Postal Service were to reduce its payments into the CSRS (to avoid overpaying and creating a surplus), the federal budget would take a big hit and “cost” the federal government over $4 billion a year. Congress was having none of that, so it came up with three solutions to the pension problem.

First, it retroactively transferred responsibility for funding the cost of CSRS benefits attributable to the military service of postal employees from the Treasury to the Postal Service. That handed the Postal Service a $27 billion obligation and went a long way toward offsetting the effect of reducing the CSRS payments.

Second, the Postal Service was not allowed to keep the money it was saving in reduced CSRS payments. Instead, for three years it had to use the savings — about $3 billion a year — to pay off a loan to the Treasury; in the fourth year, it had to put the money in escrow.

Third, it required the Postal Service to report to Congress on how it could use the CSRS savings realized after fiscal year 2005. That meant the Postal Service had little hope of eventually being able to keep the $3 billion a year down the road.

Let’s take these aspects of the Postal Pension Reform Act one by one.

Transferring the military obligation

The issue of pensions for veterans has a long, complicated history, but at its heart is a basic question. When a vet takes a job at the post office, his or her prior military service counts as annual credits toward pension eligibility, but who should be responsible for that portion of the vet’s pension costs, the federal government or the Postal Service?

The Postal Service argued that it shouldn’t be responsible for pension costs of vets that accumulated before taking a job at the post office. The Postmaster General pointed out that 90% of the obligation was incurred even before the Postal Service was established as an independent entity in 1971. Plus, the Postal Service gave hiring preference to veterans, so there were a lot of them working at the post office, and it was unfair that the Postal Service should have this obligation on its books.

President Bush’s administration argued, however, that the Postal Service should pay the full cost of its employees’ pensions, including those earned in military service, because the credits have pension value only by virtue of the Postal Service having hired veterans in the first place.

The Bush administration won the debate, and one of the Pension Reform Act’s main changes to the method of funding CSRS was that the responsibility for the veterans’ pension credits was transferred from the Treasury to the Postal Service. That meant the Postal Service incurred a $27 billion obligation, which came to about $1.5 billion a year in payments to the Treasury.

The Pension Reform Act did not, however, put an end to the controversy over who should be responsible for the military credits in the CSRS pension. Many people continued to argue that it was wrong for the Postal Service to get stuck with the obligation, while others maintained that the military credits were the Postal Service’s problem.

For example, the Acting Director of the OPM, Dan Blair, told the Senate in 2005 that he believed the Postal Service should continue to be responsible for the military credits. “Since the Postal Service uses and receives the benefits of this human capital tool in the form of recruitment and retention of its own employees,” said Blair, “it should pay for its full cost. There is no basis for the taxpayers to subsidize any element of the Postal Service's compensation package.” (Blair, by the way, would subsequently go on to become the first Chairman of the Postal Regulatory Commission, the successor agency to the Postal Rate Commission.)

The Heritage Foundation, the right-wing think tank that has longed advocated privatization of the Postal Service, similarly argued that returning the burden of the military pensions to the government would “primarily serve to subsidize mass mailers while making it more difficult to bring federal spending under control.”

Such arguments prevailed in 2003 when the Postal Pension Reform Act was passed, but three years later, Congress would reverse itself and shift the military pension costs back to the Treasury. But that victory for the Postal Service came with a lot of strings attached, as we’ll see shortly.

Putting the reduced CSRS payments in escrow

In order to avoid the $71 billion surplus from accumulating in the CSRS, the OPM proposed legislation to reduce the Postal Service's annual payment from $4.7 billion to $1.8 billion for fiscal 2003 and to make similar adjustments in subsequent years. That meant, in effect, that the Postal Service would “save” almost $3 billion a year by making lower payments to the CSRS fund.

But Congress did not want to allow the Postal Service to keep this $3 billion a year. According to budget scoring, that would end up increasing the federal deficit. So Congress directed the Postal Service to use the first three years of savings (2003-2005) to pay down its debt of nearly $12 billion, owed to the Treasury for borrowing to help cover its deficits. After that, starting in 2006, the $3 billion in annual savings would be put into an escrow account while Congress decided what to do with it.

The 2003 Pension Reform Act thus reduced the Postal Service’s payments to the CSRS, but it also required the Postal Service to give $1.5 billion a year to the Treasury for the military credits and to pay out $3 billion a year (to repay loans and then into the escrow account).

Overall, then, the Act was basically a quid pro quo: The Postal Service got its CSRS pension payments adjusted, but it got stuck with a $27 billion bill for military service benefits, and it had to put the pension savings into escrow. The money was not returned to the Postal Service, which might have been used it to avoid a rate increase, to make capital improvements, or to expand its products and services.

Using the CSRS savings for retiree health care

While Congress was considering the postal pension legislation in 2003, the Postmaster General came up with a suggestion about how to handle the $27 billion in military pension costs. Transferring the obligation back to the government would essentially give the Postal Service the money, which would take money out of the Treasury and add to the federal deficit. So the Postmaster General suggested that the the money could remain in the Treasury and be put into a separate account designated as the “Postal Service Retiree Health Benefit Fund.”

Such a move would return the obligation for vets’ pre-USPS pension obligations back to the government where it belonged, but the Treasury wouldn’t need to hand over billions to the Postal Service. (Most of that those billions, by the way, had been paid out long ago to veterans of World War II and Korea.)

As for CSRS savings, Congress was not very interested in simply letting the Postal Service have the $3 billion a year. In 2004, the CBO estimated that canceling the payments and letting the Postal Service keep the money would cost the unified budget $12.5 billion through FY2009 and $35.7 billion through FY2014.

A House committee chaired by Tom Davis came up with an idea similar to what the Postmaster General had suggested for the military credits. Davis recommended that the Postal Service set up a Retiree Health Benefits Fund, and the money going to the escrow account could be put into this new fund.

What this all boils down to is this: Congress did not want to transfer the $27 billion obligation for veteran pensions to the Treasury, and it did not want to reduce the CSRS payments by $3 billion a year. If had to do these things, something else needed to be done to balance out the costs to the Treasury. The solution was to create a Retiree Health Benefits Fund and to put the money there. That way it stayed in the Treasury, where it would help out with the federal budget.

Congress addresses the pension problem, again: The PAEA of 2006

By 2006, it was time for another round of postal reform, but the pension issues continued to cloud the debate. The Postal Accountability and Enhancement Act (PAEA), sponsored by Davis in the House, and by Collins and Carper in the Senate, did a number of things. It changed the rate system, turned the Postal Rate Commission into the Postal Regulatory Commission, and gave the Commission more power. It also addressed the retirement funds in several ways.

First, the PAEA relieved the Postal Service of responsibility for covering the costs of military experience. It transferred responsibility for costs related to CSRS military service credit from the Postal Service back to the Treasury, both retroactively and prospectively; this included all CSRS military service costs for postal employees since the inception of the Postal Service in 1971. That obligation for the $27 billion in military credits was thus returned to the Treasury, once and for all.

Second, the PAEA established the Postal Service Retirement Health Benefit Fund. The Postal Service thus shifted from a “pay as you go” model and began prefunding the health benefits of current and future postal retirees.

The RHBF was initially funded with $17 billion from the CSRS surplus associated with the shift in military pension obligations, plus the $3 billion that had been put in escrow from the suspension of the annual CSRS payment. The fund was thus quick started with $20 billion diverted from the CSRS.

Third, the PAEA required the Postal Service to make annual payments — ranging from $5.4 billion to $5.8 billion per year — into the RHBF over a ten-year period, from fiscal years 2007 through 2016, and to pay off the rest of its liability (as determined by the OPM in 2017) in the years 2017 to 2056.

Frontloading the payments

As the new GAO report states, “the payments required by PAEA were significantly ‘frontloaded,’ with the fixed payment amounts in the first 10 years exceeding what actuarially determined amounts would have been using a 50-year amortization schedule.”

The GAO report does not fully explain why that happened, though. The payments could have been amortized over a much longer period, like forty or fifty years, which would have led to significantly smaller annual payments. In fact, in 2005, when the OPM’s Dan Blair recommended creating a retiree health care fund, he suggested setting up a forty-year payment schedule.

In 2003 the GAO estimated that the Postal Service had "substantial" obligations associated with retirees' health benefits, somewhere between $40 billion and $50 billion. With $20 billion in the fund from the get-go, a payment schedule of forty or fifty years would thus have required payments on the order of a billion a year.

But the Postal Service was looking at the possibility of “saving” about $4.5 billion a year in reduced payments to the CSRS — $3 billion from reduced CSRS payments and $1.5 billion for not having to pay the military obligation. If only one billion were put into the RHBF, however, the Treasury would end up getting $3.5 billion less each year.

Congress needed a way to ensure that $4.5 billion kept making its way from the Postal Service to the Treasury. That’s essentially why Congress came up with a plan to frontload the fund with an aggressive ten-year schedule of annual payments of about $5.5 billion.

The USPS OIG puts it this way in a 2009 report: “Because the Administration and Congress required the new law [PAEA] to be budget neutral, the Act also required the Postal Service to make 10 payments to the Department of Treasury, approximately equal to the annual amount of the reduced payment from the escrow and military service relief, for the purpose of prefunding the Postal Service’s retiree health care liability.”

Mandating those huge payments wasn’t simply about ensuring that the Postal Service covered its retiree health care liability (a liability that wouldn’t come due for decades), and the size of the payments wasn’t based on actuarial calculations. The payments were all about making sure that the billions the Postal Service was overpaying into its pension fund would continue to help out the bottom line of the unified federal budget.

Pay now or pay later

That’s the history of how the $5.5 billion payments came about. They’ve been an onerous burden from the start, and the Postal Service hasn’t really been able to make any of the payments on its own. It has had either to borrow back from the Treasury or simply default on the payments.

The new GAO report analyzes several proposals about what to do about the problem, as proposed by the House, the Senate, the Administration, the Postal Service, and the OIG. The details are extremely complicated, and making projections about how the different proposals would work out is further complicated by several unknowns, like the rate of inflation for health care costs, future interest rates being earned by the money accumulating in the fund, the size of the workforce, and so on.

The gist of the report, however, is clear. Any significant reduction in the annual payments would jeopardize the Postal Service’s ability to cover its liabilities down the road. If the payments are smaller in the near term, they will be bigger in the long term.

The GAO acknowledges that “some stakeholders have argued that such prefunding is primarily responsible for USPS’s dismal financial condition and is unfair, arguing that no other entity is required to conduct such prefunding.” The GAO, however, dismisses this argument. It cites a 2011 OPM Inspector General report that said postponing prefunding would be “financially risky,” and it says that significantly reducing the payments now will increase the possibility that the Postal Service won't be able to make the larger payments that will come due decades from now.

As the GAO states, “OPM’s Inspector General reported that future USPS customers (ratepayers) will have to pay for expenses that the USPS is incurring today and added that deferring payments will likely hurt the USPS’s ability to compete in the future and affect its ability to improve its financial situation.”

The House, Senate, and Administration proposals

The proposals put forward by the House, Senate, and Obama Administration each requires significantly large payments into the RHBF, but they are calculated in different ways. It's not easy comparing apples and oranges, but the new GAO report does an excellent job explaining the different plans and possible scenarios. Roughly, here's what they come to.

The House bill reduces the 2011 payment from $5.5 billion to $1 billion, but increases the 2015 and 2016 payments from around $5.7 to $8 billion. Overall, for the four-year period 2013 through 2016, the House bill is actually more demanding than the current situation. It would require over $27 billion in payments, as contrasted with $23 billion required by current law.

The Administration bill eliminates the $5.5 billion payment for FY 2011, reduces the 2012 payment to $0.8 billion and the FY 2013 payment to $1.3 billion. But in 2014, the payments return to a level comparable to the one set under PAEA, i.e., about $5.5 billion. For 2013 to 2016, the total payments would come to $18 billion, less than current law’s $23 billion, but still a significant burden.

The Senate bill completely repeals the mandated payments for 2011 through 2016 and replaces them with a 40-year amortized payment schedule. It would also reduce the pre-funding requirement to 80 percent of the projected liability, as opposed to current law and the House bill, which aim for 100 percent. According to the GAO report, the payments would come to about $4.4 billion a year, or about $18 billion for the 2013-2016 period (roughly the same as the Administration’s proposal).

These three proposals thus require significant payments over the next few years and wouldn't do very much to relieve the Postal Service of the burden placed on it by PAEA. Two other proposals take a different approach, the Postal Service’s and the OIG’s.

The USPS proposal

The Postal Service proposes taking over the fund itself. The GAO does not consider this approach in any detail because it is working on a separate report on the topic. The Postal Service was apparently not happy that the GAO went ahead and issued its report without giving sufficient attention to the Postal Service's plan. In response to a draft of the report, the Postal Service said that “releasing this report is inappropriate because, in its view, the solution to managing its health care costs is to reduce the cost of future health care coverage by allowing USPS to sponsor its own medical plan.”

According to the Postal Service, “Having an affordable arrangement, utilizing best practices found in the private sector, will serve Postal Service employees and retirees well.” The phrase "best practices found in the private sector" probably means that the Postal Service would cut benefits for its retirees and bring them down to a level comparable to what's offered by private corporations. The private-sector comparability standard rarely means good things for postal workers.

On the other hand, making the Postal Service responsible for the retiree health care fund might be better than having Congress remain in charge of it. That would depend on many unknowns — like how much power postal workers and their unions had over the funds, how the funds were invested, how secure the funds were from being raided, and so on.

One thing is for sure. There are many investment firms out there that would love to get their hands on the $44 billion in the fund right now. The commissions on handling the investment of that money in the stock market would be huge. That may be why investment banks like Evercore (hired by the Postal Service for "restructuring advice") and Lazard (hired by the NALC) are so interested in the future of the Postal Service.

There's more about the Postal Service's proposal in this 2011 white paper. It's rather vague on the details about how managing the fund itself would save money, so it will be interesting to see what the forthcoming GAO report has to say on the subject.

The USPS OIG proposal

The Inspector General proposes yet another plan, informally called the Seal and Grow Approach. It’s a variation of the “pay as you go” method that was in place before the PAEA created the retiree health care fund. The Postal Service would stop prefunding and instead pay its share of premium payments for retirees and beneficiaries as they become due.

The existing fund would be left to grow with interest, with no other cash inflow or outflow, until the Postal Service’s liability was fully funded. The OIG estimates that the fund would grow from $44 billion (its level as of September 2011) to $90 billion in 21 years (its estimated liability at this time).

The OIG therefore argues that the $5.5 billion payments mandated by PAEA are completely unnecessary. According to a 2009 OIG report, “The Postal Service could pay on average $4.0 billion less each year from FYs 2009 to 2016 to prefund its retiree health benefits and still achieve the same level of funding anticipated under OPM’s assumptions.” In other words, rather than annual payments of $5.5 billion, the Postal Service could be paying about one billion a year for retiree health care.

The OIG also believes that it should not be necessary for the fund to be fully funded, as required by PAEA. The OIG notes that many businesses — if they even have a retiree health care fund — are targeted at much less than 100 percent. For example, the OIG found that 38 percent of Fortune 1000 companies that offer retiree health care benefits prefund them at a median funding level of 37 percent. The Department of Defense prefunds its retiree health benefits and it has a 100 percent target funded percentage, but as of September 30, 2010, it was funded at 38 percent. The OIG therefore says that it would be sufficient if the RHBF were funded at just 30 percent.

Congress to the rescue

While it may make sense for the Postal Service to prefund its retiree health care benefits at some level or another, it’s clear that the current mandate is the main cause of the Postal Service’s financial crisis. Diversion to the Internet, a weak economy, and the reduction in postal services (like slowing down First Class mail) are contributing factors, but they account for a relatively small portion of the deficit. The big problem is the health care mandate. It accounts for over 80 percent of the total deficit that's accumulated since 2006 ($33 billion out of $41 billion). As the OIG says, making prefunding payments at the current levels will simply bankrupt the Postal Service.

The payments — even when they aren’t made — are already having a terrible effect on postal operations. They make the monthly, annual, and cumulative losses look many times worse than they actually are. The staggering losses are cited constantly by Postal Service management to justify reductions in service, like cutting hours at 13,000 post offices under POStPlan, and they are demoralizing the workforce. The losses are the regular stuff of headlines, and it's no wonder that many people think the Postal Service is a defunct dinosaur heading off a fiscal cliff. That can’t be good for business.

Congress created this problem in 2006 when it tried to correct the earlier mistake of overfunding the CSRS. But mandating that the Postal Service frontload the retiree health benefit fund with an aggressive payment schedule was an even bigger mistake, and it has turned out to be a disaster.

It’s now up to Congress to fix its mistake. If past history is any indication, however, there’s little reason to be optimistic. Congress will probably do what it does best: fix one problem by creating several new ones.